Canny investors sell out as big gains come before a fall

Rod Myer

OK, SO the markets are on the up and up. The All Ordinaries Index is up 17 per cent in six months, the US market is within a hair's breadth of its all-time highs and more money flowed into US mutuals in January than at any time since 2001.

It's a nice feeling for investors who seem confident of enjoying a little worry-free levity after the trauma of the past five years. But while not wanting to appear churlish, our first column for 2013 may just sprinkle a little rain on the investment parade.

This week's analyst, Alan Clement, a member of the Australian Technical Analysts Association, has produced a chart comparing the Dow Jones Industrial Average against what is known as the Bullish Percent Index (BPI). The BPI is a breadth indicator that measures how many stocks that make up an index (in this case the Dow) are giving off buy or sell signals. So if the general market is rising along with the BPI then the rally is broad-based and vice versa. It's a useful tool for investors in many markets.

However, Cambodia, where your correspondent was ensconced writing this story, is probably the exception as the market is made up of one local company, the Phnom Penh water authority.

There are a couple of phenomena to note about the Dow chart at the moment. While it has been in an uptrend since October 2011 it is now in a rising wedge formation, which is a sign of loss of momentum. It emerges when each upswing has less thrust than its predecessor, leading to a narrowing of the difference between highs and lows.

Technical analysts watch such formations closely and will generally interpret any fall through the lower of the red support lines making up the current wedge as a sell signal. An added depressant is that as the Dow approaches its 2007 high of 14,100, significant market resistance is likely to further impede its progress.

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Now back to the BPI. It is giving us a reading of 73, which means that 73 per cent of the stocks that make up the index are giving buy signals.

That might sound reasonably positive but back in March last year the figure was 96 per cent and that difference has formed a downward trend line on the BPI. This in turn has created a divergence between the Dow and the BPI. And, says Clement, that is an indicator that some of the market's more canny investors are selling out to lock in profits from the run up.

When the wider investing public cottons on to that there is likely to be a sell-down in the Dow. For those who would like a little evidence for this hypothesis, look back to the early months of 2011 when there was a similar divergence. Then the BPI proved prescient with the Dow falling out of bed in July.

History tells us that November to January are traditionally strong months for the market so any fall may begin as early as this week.